Comments on "Relationships between the Overall Property and Its Parts, and the Three Approaches to Value".(LETTERS TO THE EDITOR

In "Relationships between the Overall Property and Its Parts, and the Three Approaches to Value" (Winter 2009), Mark Pomykacz, MAI, provides a framework for breaking the overall value of what he refers to as a business asset into the value of the real estate, the value of the personal property, and the value of business intangibles. This framework is comparable to one provided in Figure 2.1 of The Appraisal of Real Estate, 13th edition (Appraisal Institute, 2008, page 30), where the going-concern value of a business enterprise is divided between tangible property (composed of personal property and real property) and intangible property of various types. At a philosophical level, I agree with these two essentially identical frameworks as applied to commercial real estate properties because I have felt for many years that most commercial properties, and especially multiple-tenant properties, are really business enterprises that may or may not include personal property, but almost always include one or more types of intangible property. However, unlike Mr. Pomykacz, I do not believe that the going-concern value can be meaningfully split into various components, including real estate, personal property, and business intangibles. The appraisal community's collective view on the partitioning of going concerns into components could potentially make a tremendous difference in how the field of real estate appraisal might evolve over the next few years and beyond.

In his article, Mr. Pomykacz offers the opinion that "good appraisal practice ought to require that appraisers explicitly state their opinions as to the combination of assets typically found in the market and what combination is under appraisal, especially when the two differ" (page 68). This is a reasonable request and can be easily addressed by commercial real estate appraisers with a simple statement in an appraisal report that the appraised value is for a going-concern real estate enterprise (if this is the appraiser's opinion) and thus includes the value of real estate, the value of various intangible assets, and possibly the value of personal property when the overall property requires personal property in order to fulfill its function.

The article includes repeated statements by the author that suggest an appraiser may need to "employ a residual technique, an allocation technique, or some other technique to discern the value of the real property" When should these techniques be employed? This can perhaps be answered by looking to the needs of the client. But before doing this, it is necessary to address some of the theoretical issues that must be overcome before real property value can be estimated through employment of "a residual technique, an allocation technique, or some other technique."

In his article, Mr. Pomykacz describes how a residual technique could be used to estimate a real property value (page 71). In particular, be suggests that the value of real property can be estimated by projecting the portion of estimated net operating income that can be identified with personal property as well as the portion that can be identified with business intangibles and then capitalizing the residual income into an estimate of real property value. 1 question whether this can be done in a definitive and defensible manner.

Specifically, the net operating income that would be used in the residual technique is the net operating income for the overall property that is the going concern. With a going concern that utilizes personal property, the assumption is that all three major component categories-real estate, personal property, and business intangibles-must work together in synergistic form in order for the enterprise to capture the full income stream. For a business enterprise (real estate based or other) that requires personal property, removing either the personal property or the business intangibles might greatly harm the enterprise's ability to generate the full income stream and perhaps even endanger its prospects for continuing as a going concern. For a business enterprise that does not require personal property, removing the intangibles might similarly harm the enterprise's ability to generate the full income stream and likewise endanger its prospects of continuing as a going concern. As one example, it is difficult to envision much success for a hotel enterprise that chooses to part with its furniture, fixtures, and equipment (personal property) or its business plan (an intangible).

In order to use the residual technique for estimating real property value, an appraiser of a going concern would need a definitive mechanism for estimating the going-concern value of the personal property, the going-concern value of the business intangibles, the net operating income for the overall property, the capitalization rate for the going-concern personal property, the capitalization rate for the going-concern business intangibles, and the capitalization rate for the going-concern real estate. This means six estimated items are needed to estimate a seventh unknown item, the real property value. How is the appraiser supposed to gather market information regarding component values and component capitalization rates needed for a residual technique since the personal property and business intangibles are generally worth more to a viable and continuing going concern than in a sale to an outside party?

The going-concern value for the personal property and business intangibles is not the same as the value to an outsider who would likely deploy them in a different setting. In essence, market transactions of going-concern components do not occur since a component that is separated from the overall property is by definition no longer part of the going concern. Continuing with the hotel example, the sale price of the personal property of a going-concern hotel enterprise to an outsider would ordinarily be but a fraction of its going-concern value to the existing hotel enterprise. The value of continued use of the personal property is almost always higher than its use to an outsider. Thus, the value that the personal property can bring in a market transaction should not be interpreted as equivalent to its going-concern value to the enterprise.

The going-concern value for enterprise business intangibles is similarly difficult to estimate. Business intangibles are often difficult to identify and segregate in a meaningful manner, but even when one or more categories of business intangibles can be separated and offered for sale, the market value to another party should not necessarily be interpreted as its going-concern value to the selling enterprise. How does one estimate the going-concern value of the reputation of an enterprise, its trained workforce, or its superior management team? Where does an appraiser gather market information that will support these estimates?

An allocation technique, as referenced by the author, refers to any of a variety of techniques that have been offered over the years for allocating overall value to the various components of a going concern. The various allocation techniques that have been published in the real estate appraisal literature over the past twenty years or so are typically contingent on a host of questionable market assumptions. These techniques (1) are often in conflict with previous techniques offered for the same property type by other writers, (2) may well produce results that are inconsistent with examples provided within the same presentation, and (5) are typically so narrow in their application that they are suggested for only one class of property within a single property-type category. In a nutshell, these techniques are universally flawed because there is no available theory that uniquely and definitively supports the allocation process. Hence, it becomes an issue of one person's opinion against another's, with no means available for meaningfully resolving the dispute.

The allocation process should not be confused with the valuation process. Whereas the valuation of real estate has a long-established tradition based on a well-defined body of principles and assembled knowledge, I am not aware of any such tradition for a process of allocation as it relates to personal property and business intangibles. Mr. Pomykacz may have knowledge of well-established theoretical support for the allocation process that is not generally known. If so, he did not provide such support in his article.

Mr. Pomykacz mentions the possibility of "some other technique" for identifying real property value. Although he does not elaborate, he suggests (at page 75) that the cost approach is available to estimate the going-concern value of the personal property and going-concern value of the business intangibles, which can then be subtracted from the value estimate for the overall going concern to yield a value estimate for the real property. Where should an appraiser go to gather the information needed to do this? In particular, among the three common value approaches, most appraisers would agree that the cost approach is the most difficult to defend, primarily because of problems in estimating depreciation. Surely, estimating the cost of the going-concern value of personal property using the cost approach and estimating the cost of the going-concern value of business intangibles using the cost approach would not be easy or especially accurate.

In order to gain insight regarding the article's recommendations, it is helpful to evaluate the useful ness of what Mr. Pomykacz has presented relative to the four categories of work a commercial appraiser currently does or might wish to do in order to meet client needs.

The first category of work includes appraisals for owners and developers, and their investors and lenders; this is by far the largest category of valuation work for a typical commercial property appraiser. It is likely that many appraisers performing this type of work have not communicated well that the value estimate provided is for a going-concern enterprise and therefore is contingent on the synergistic combination of real estate, personal property (in some cases), and business intangibles. Although it may be obvious to appraisers that removing any one of these components would diminish the value of the overall enterprise (perhaps jeopardizing its viability as a going concern), this still needs to be expressed whenever a real estate enterprise is being appraised. Since the value of a real estate enterprise is often used as collateral for associated loans, appraisers need to regularly remind lenders that loan-to-value ratios involving a real estate enterprise should be set low enough to reflect a possibly much lower value for a stand-alone real estate component (as well as for the other separate components) in the event of a going-concern failure. Notably, an overall value estimate of a going-concern real estate enterprise does not require specific estimates for the going-concern value of the personal property and for the going-concern value of the business intangibles.

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